I've spoken with a few cleantech investors and startup CEOs lately, who naturally mention and opine about the recent high-valuation fundraisings in the web space, but for the most part without a sense that it really matters to anyone in the cleantech sector.

But far from it being inconsequential or just something to feel a twinge of jealousy about, instead I'm starting to see some real implications -- both good and bad -- for the sector as a result of what's increasingly looking like a new web bubble (or "wubble" as I've been calling it on twitter, because then at least it sounds small and cute and manageable).

 

The Good:

First and foremost, cleantech VCs are just glad to see any venture capital successes in any sectors right now, what with LPs being so down on the overall asset category.  So any validation of the venture capital model should help with fundraising, particularly for generalist funds with some cleantech activity.  And cleantech CEOs are happy to see any VCs right now with money to invest.

Secondly, the cleantech venture sector is in dire need of a secondary market, or "interim exits", that would allow founders and investors to get some earlier returns, even if not complete exits.  This is true for all venture sectors, btw, but especially true in many of the most popular cleantech sectors where the gestation-and-commercialization cycle has been so long.  So if the "pre-IPO public offering" pathway being opened up by Facebook and Groupon allows some solar and fuel cell startups (for example) to achieve some partial exits by taking the same path, then that can help the sector mature as an investment area.

Third, those of us urging more web-like and other capital-lite models in cleantech now have even more inspiration to go find those.  I'll discuss that more below.

 

The Bad:

I have to admit I feel more trepidation than eagerness when I see this current "wubble" building up.  

For a while now, in many venture-backed sectors including cleantech, a few smaller banks have been using the special-purpose vehicle route to enable "high-net worth individuals" at increasingly low (or at least unverified) actual net worth levels to invest in privately-held companies, at inflated valuations.  I and many others in the sector have received the pitch of "Now you have the opportunity to invest in a [brand-name VC] backed company before the IPO!" multiple times, for some of the most-hyped companies in the sector.  This pitch builds on carefully-built publicity and hype around a company, plus the brand equity of their venture backers, to bring in a pool of small-check investors who ordinarily would be locked out of investing in such privately-held companies.

Here's one overly-simplified way it works:  The bank in question creates an SPV, which then extends a term sheet for a 'venture round' to a recognized startup.  The term sheet is at a pretty high valuation, higher than a typical VC would be willing to value the company.  Why?  Because the banker actually isn't as motivated around returns.  It's not their money, the SPV is just a pass-through vehicle formed to satisfy SEC restrictions around the number of investors a privately-held company can have without having to report a lot of private information.  And the bank takes in fees from investors who participate in the SPV.  So the SPV is willing to pay a pretty high premium in order to be the lead investor (or at least major participant) in the round, just to gain access to those fees.  Of course, the higher the valuation, the more likely these individual investors won't be interested in participating.  But a) bankers make some pretty compelling pitch books; b) these individual investors aren't very sophisticated about making sense of private equity valuations; c) the bankers don't have to convince ALL investors, just enough of them, and given a deep enough rolodex they can reach a lot of individuals; d) just like in everything else in life, the level of publicity and hype obfuscates a lot of reality; and e) if the SPV falls a bit short, they can reduce the valuation, or just put in a smaller amount of money.

The most important criterion for the bank, therefore, isn't "what's this company worth", but instead "can we sell this story?"  In effect, these are angel-led follow-on rounds... with a term sheet written by a banker... and lots of really small angels in the round... and often some of the proceeds going right out the door to founders and perhaps some existing venture investors.

The existing venture investors get to point LPs to a big write-up, because a big round was raised at this new higher valuation.  And when the valuation is inevitably "leaked" it becomes a PR event in and of itself, lending more of a sense of massive momentum around the company, which leads to even more news coverage, etc etc.  When founder shares are then made available on one of the various secondary markets for privately-held stocks, those sales now of course also are based upon this new, higher valuation plus the additional publicity, so you can start to see implied valuations that are quite high.

This hype and valuation cycle lends itself very well to an eventual high-flying IPO for a deserving company.  Or even without that, to subsequent semi-exits by founders and early investors either through those secondary markets or (more likely right now) via redemptions after subsequent "venture" financings.  

Which is also why bigger-named bankers are now getting in the act.  Because by organizing an SPV-led venture round like this, they not only make fees for that round, if they can also thereby make sure they're the bankers who manage the eventual IPO, they're in line to make huge additional fees at that time.  

None of the above is inherently nefarious, it could be a good answer to a problematic IPO environment.  It certainly opens up good opportunities for founder and early investors to be rewarded in advance of an IPO.  And it gives more high net worth investors an opportunity to make direct investments in venture-backed companies, rather than the other routes of having to either be very early angel investors or indirect investors as LPs in a venture fund.  To be clear, I'm not at all arguing simplistically that "hype is bad."  Hype can be good, too, and either way it's certainly a powerful and legitimate tool for venture capitalists to deploy when seeking out good returns on their investments.  And I'm not at all against the continued democratization of venture capital.  In my opinion, that's a good thing, if done right.  And hey, even investment bubbles can have some good impacts, if their inevitable "pop" doesn't have too many destructive side effects.

But as you can tell, I believe the current hype-fueled process and deal structure also provides strong misincentives for valuation inflation along the way.  And for poor quality control by the bankers.  And while as an investor that doesn't bother me per se, it worries me if there ends up being a backlash when these high valuations don't end up working out well for participants in the SPVs or secondary markets and there's a regulatory/political backlash at some point, meaning that this new exit pathway gets shut down.  Or if these now very-hyped, very highly-valued companies fail to follow-through on blockbuster IPOs and thus end up lending the entire venture capital category yet another black eye among LPs.  Or if, when this bubble pops, it has too many destructive economic side effects, which is why it especially bothers me to see the lax qualifications of "high net worth individuals" I've gotten the impression are sometimes being used -- "click here to agree you're a high net worth individual", etc.

And then there's this, specific to cleantech:  I'm now seeing a fair bit of anecdotal evidence that this type of story in the web sector, in the context of an overall brutal VC fundraising environment, is redirecting VC resources out of cleantech and into web investing.  Venture investors wearing both Web and Cleantech hats now much more obsessed with the former.  And now even a few cleantech colleagues at generalist venture firms who are being told to go find new jobs, because the firm needs to raise a new fund and "faster, bigger" exits in web investing are where the firm needs to pitch prospective LPs, not cleantech.  Which fits with what one LP I spoke with a while back told me, "venture capital only makes sense when there's a bubble."  Well, if there's a bubble in web investing and not in cleantech investing, this will therefore be the reaction of LPs, as reflected by their GPs.

Okay, so what, the money should go where the returns are, right?  Indeed, very selfishly, having fewer cleantech investors out there competing with me for deals is probably a net good thing.  I've never seen more attractive, uncompetitive deals in cleantech venture capital than I'm seeing right now. But if it means having fewer good co-investors and follow-on investors I can turn to, that's not good.  And for cleantech CEOs out there, this is a very bad thing, because it portends even more difficulties in the future in trying to raise the capital necessary to get cleantech startups up and off the ground.

 

The "Ugh":

The last thing I'll mention is that these stories also very legitimately challenge the cleantech sector overall, because they point to a core difference between the kinds of Groupon and Facebook startups that can command this type of attention, and most cleantech startups.  And that difference is, in short, network externalities.  The "virtuous cycle".  The way these companies build momentum that feeds on itself.

The more customers use Groupon, the more vendors want to use it.  The more vendors use it, the better the deals, the more customers use it.  And so on.  I don't have to buy into the specific inflated valuations being thrown around out there in regards to Groupon, but I do have to admire their business model and understand why it should command a high valuation in general.  Virtuous cycles are what made the venture capital category what it is.  It's not the only kind of business VCs can invest in to make returns, but it's at the core of the VC model, insofar as it's typically applied and talked about among LPs and the popular media.  It leads to really fast growth and high valuations, when it works (easier said than done, of course). 

So far, despite a lot of looking, I haven't seen many examples of virtuous cycles in terms of the business models being deployed in cleantech.  Instead, I've seen lot of emphasis on cost-advantaged manufacturing of products that will then compete against each other on price, which if anything is a vicious cycle.  Not a lot of products or services where the more customers buy them, the more valuable they are.  Some exceptions do exist (I like lighting controls, for example), but if you're looking for truly web-type network externalities in cleantech venture capital, we haven't seen too many of them over the past decade-plus.

I hope the "wubble" doesn't end up having too many negative impacts on the cleantech sector or the venture capital category overall.  But even more so, I hope that cleantech entrepreneurs learn the key lesson from it, which is to go find and launch business models that will benefit from virtuous cycles in the energy, water and materials markets.